Option pricing-- valuing derived claims in incomplete security markets

Abstract

<p>The purpose of this paper is to investigate the inherent relationship between the theory of the economic role of options and various approaches to option pricing. It is argued that the economic theory underlying the pricing of options should dictate why and how options are valued. The fundamental issue is that the assumptions of existing option pricing models cause options to be valued in a market environment in which options serve no.economic purpose and therefore would not necessarily be issued. Hence a paradox exists.</p> <p>A new approach to option pricing is suggested. Options should be valued based on the assumption that they exist for the purpose of providing completeness for the capital market. Thus the efficiency of the economic system is enhanced. The approach which is suggested is developed in the context of the standard Capital Asset Pricing Model. This has resulted in a new option pricing formula which contains a market-effect variable - the expected return on the underlying stock. The reason as why such a variable exists is explained.</p>